Introduction to Accounting & Financial Analysis

BESS SF class 2013-14

Prof. Gerard McHugh School of Business, Trinity College

The big picture...... Financial Management

The hurdle rate should reect
the riskiness of
investment and the
mix of debt
and equity used to
fund it

The return should reect
the magnitude
and timing
of the cash ows
as well as
all the side effects

The optimal mix of debt and
equity
maximises the
value of the rm



The right kind of debt matches the
tenor of the rms
assets




How much cash you can return
depends
upon current and
potential
investment
Opportunities

How you choose to return
cash to the
owners will depend
on whether they
prefer cash
or buybacks

The Investment Decision Invest in assets that earn a return greater than the minimum acceptable hurdle rate

The Financing Decision Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations

The Dividend Decision If you cannot find investments that reach your minimum acceptable hurdle rate, return the cash to the owners

Maximise the value of the business

Adding accounting into the financial management story

The Capital Market: Trading Value The Firm: The Value Generator
Cash from Loans Interest and Loan Repayments

The Investors: The Claimants on Value

Secondary Debtholders

Debtholders

Cash from Sale of Debt

Operating Activities

Investment Activities

Financing Activities

Cash from Share Issues Dividends and Cash from Share Repurchases

Shareholders

Cash from Sale of Shares

Secondary Shareholders

B alance Sheet

Income Statement

C ash Flow Stateme nt

Statement of Shareholders' Equity

The Financial Statements: Information on Value

Figure 1.1 The firm, its claimants, the capital market and the financial statements. Arrows indicate cash flows.

Accounting is the business language through which we can answer these questions

The three key financial statements

! The balance sheet, which summarizes what a firm owns and owes
at a point in time. ]

! The income statement, which reports on how much a firm earned

in the period of analysis

! The statement of cash flows, which reports on cash inflows and

outflows to the firm during the period of analysis. The statement of cash flows is prepared from the income statement (along with some additional underlying data)

The Balance-Sheet Model of the Firm

Long lived real assets

Fixed assets

Short term liabilities

Current liabilities Debt

Short lived assets

Current assets

Debt obligations

Investments in securities and other firms Assets that are not physical like patents and intellectual rights

Financial assets

Long term liabilities

Other liabilities

Intangible assets

Equity investment in the firm

Equity

The Balance-Sheet Model of the Firm

The Investment Decision Current Assets Non-current Assets 1 Tangible 2 Intangible Current Liabilities Long-Term Debt Shareholders Equity

What shortterm and long-term investments should the firm engage in?

The Balance-Sheet Model of the Firm

Current Assets Non-current Assets 1 Tangible 2 Intangible

The Financing Decision Current Liabilities

How can the firm raise the money for the required investments?

Long-Term Debt Shareholders Equity

Footlocker Inc. operates in the athletic footwear and apparel industry

! Footlocker is a leading retailer of athletic footwear and
apparel [year end January] ! Over 3,400 stores in 21 countries ! Annual sales (turnover) in 2012/13..$6.1 billion producing a Net Income of $397m [2011/12; $5.6billion producing net income of $278m]

Footlocker Balance Sheet 2012 [A = L+E]

Current Assets $2,363m Current Liabilities + + Property and Equipment + Other Assets $490m $514m $3,367m Non-current Liabilities + Shareholders Equity $354m $2,377m $3,367m $636m

Footlockerrepresented
Current Assets $2,363m Non-current Assets 1 Property.. 2 Other..
$490m How the firm raised the money to fund the business Current Liabilities.. $636m Long-Term Liabilities $354m

Shareholders Equity $514m $2,377m

What information is immediately visible from the 2012/13 Balance Sheet?

! Merchandise inventories [inventory for resale] stands at over ! ! ! ! ! !
$1.1billion. It represents one third of the asset investment in the business. No significant trade receivables [cash business] Substantial cash holdings which have increased by approximately $30m over the year. Relatively modest investment in property and equipment [presumably most or all outlets are leased/rented]. The company is not carrying any significant debt For the most part the business is funded by shareholders funds. Year on year it looks very positive.

Abercrombie & Fitch Inc. operates in the apparel retail industry

! Abercrombie & Fitch is a leading retailer of youth apparel
[brands are Abercrombie & Fitch, Hollister, Abercrombie Kids, Gilly Hicks. [January year end] ! 1,051 stores worldwide ! Annual sales (turnover) in 2012/13..$4.5 billion producing a Net Income of $237m [2011/12; $4.1billion producing net income of $143m]

ABERCROMBIE & FITCH CO. CONSOLIDATED BALANCE SHEETS (Thousands, except par value amounts)
February 2, 2013 January 28, 2012

ASSETS CURRENT ASSETS: Cash and Equivalents Marketable Securities Receivables Inventories Deferred Income Taxes Other Current Assets TOTAL CURRENT ASSETS PROPERTY AND EQUIPMENT, NET NON-CURRENT MARKETABLE SECURITIES OTHER ASSETS TOTAL ASSETS LIABILITIES AND STOCKHOLDERS EQUITY CURRENT LIABILITIES: Accounts Payable Accrued Expenses Deferred Lease Credits Income Taxes Payable TOTAL CURRENT LIABILITIES LONG-TERM LIABILITIES: Deferred Lease Credits Leasehold Financing Obligations Other Liabilities TOTAL LONG-TERM LIABILITIES STOCKHOLDERS EQUITY: Class A Common Stock $0.01 par value: 150,000 shares authorized and 103,300 shares issued at each of February 2, 2013 and January 28, 2012 Paid-In Capital Retained Earnings Accumulated Other Comprehensive (Loss) Income, net of tax Treasury Stock, at Average Cost 24,855 and 17,662 shares at February 2, 2013 and January 28, 2012, respectively TOTAL STOCKHOLDERS EQUITY TOTAL LIABILITIES AND STOCKHOLDERS EQUITY $ $ 643,505 99,622 426,962 32,558 105,177 1,307,824 1,308,232 371,345 2,987,401

(Restated see Note 4) $ 583,495 84,650 89,350 679,935 35,882 84,342 1,557,654 1,197,271 14,858 347,249 3,117,032

140,396 395,734 39,054 115,617 690,801 168,397 63,942 245,993 478,332

211,368 369,073 41,047 77,918 699,406 183,022 57,851 245,418 486,291

1,033 403,271 2,567,261 (13,288) (1,140,009) 1,818,268 2,987,401 $

1,033 369,171 2,389,614 6,291 (834,774) 1,931,335 3,117,032

The accompanying Notes are an integral part of these Consolidated Financial Statements.

Abercrombie & Fitch Balance Sheet

Current Assets $1308m

2012/13 [A = L+E] $691m

Current Liabilities +

+ Property and Equip. + Other Assets

$1308m $371m $2,987m

Non-current Liabilities + Shareholders Equity

$478m $1,818m $2,987m

Abercrombierepresented
Current Assets $1,308m Non-current Assets 1 Property.. 2 Other..
$1,308m $371m How the firm raised the money to fund the business Current Liabilities.. $691m Long-Term Liabilities $478m

Shareholders Equity $1818m

What information is immediately visible from the A&F 2013 Balance Sheet?
! Merchandise inventories [inventory for resale] stands at
$427m. It represents one third of the asset investment in the business. Note the significant reduction on the holdings one year ago. No significant trade receivables [cash business] Substantial cash holdings which have increased by approximately $60m over the year. Significant investment in property and equipment The company is not carrying significant debt For the most part the business is funded by shareholders funds, and supplier credit Year on year it looks solid.. only modest changes..

! ! ! ! ! !

Adobe Inc. is a large diversified software business

! Develops and sells software products for digital media
professionals, advertisers, publishers [November year end] ! Founded in 1983..Nasdaq listed ! Global reach and exceptionally profitable ! Sales for 2012 amounted to $4.4billion, producing Net Income of $832.7m [2011; sales of $4.2b producing net income of $832.8m]

Adobe Inc. Balance Sheet 2012 [A = L+E]

Current Assets $4,331m Current Liabilities + + Property and Equipment + Other Assets $664m $4,979m $9,974m Non-current Liabilities + Shareholders Equity $2,038m $6,665m $9,974m $1,271m

Adoberepresented
Current Assets $4,331m Non-current Assets 1 Property.. 2 Other..
$664m How the firm raised the money to fund the business Current Liabilities.. $1,271m Long-Term Liabilities $2,038m

Shareholders Equity $4,979m $6,665m

What information is immediately visible from the Adobe Inc. Balance Sheet
! Asset structure is unusual the largest asset is goodwill. ! Short-term investments are very substantial. ! The total asset investment stands at $9.9m, of which

$6.6m has been supplied by the equity. ! The balance of funding has come from Current and Long term liabilities.. [i.e., bank debt and supplier credit, taxes] ! Because the business has bank borrowings, it is carrying some financial risk.but look at the current assets Cash and Short Term Investments! ! Overall, the balance sheet structure is very different to Footlocker because the businesses are very different.

The three balance sheets compared [A = L+E]

Leverage ratios for selected European firms.

To summarise
! The Balance Sheet is a photograph of a business at a
specific point in time. ! The balance sheet presents the assets and liabilities split in terms of their maturity [long-term and short-term/ current]. ! From the Balance Sheet, the reader can see where the funds that the firm has sourced have been invested and also get a sense of the assets at risk. ! From the Balance Sheet, the reader can see the sources of the firms funds [equity, debt, suppliers] and thus the profile of financing.

Information about Financial Performance

A simplified view of accounting.

The Income Statement.

!
The Income Statement (Profit and Loss Account) is an historical record of performance (Revenues minus Costs) for a period of time. An Income Statement may also be prepared on a projected basis.. Common periods
n n n n n

a a a a a

week, month, quarter, half year, full year.

The Income Statement Model of the Firm

Gross revenue from the sales of products/services
Costs directly associated with the production/sales of products/services High Gross Profit Pricing premium Differentiated product Low Gross Profit No price premium Commodity Sales revenue COGS Gross profit Operating expenses Operating income Non-operating Income (expense) Income before tax

All expenses other than the those in COGS

Also known as EBIT

Non-operating income and expenses such as interest income and expense

Estimated tax that will arise on the reported profits

Tax Net Income

Earnings per share: reveals the net profit earned by each share.

EPS

Footlocker Inc. operates in the athletic footwear and apparel industry

! Footlocker is a leading retailer of athletic footwear and
apparel [year end January] ! Over 3,400 stores in 21 countries ! Annual sales (turnover) in 2012/13..$6.1 billion producing a Net Income of $397m [2011/12; $5.6billion producing net income of $278m]

Prepare common size income statements in Excel to develop your analysis.

What information is immediately visible from the 2012/13 Income Statement

! Sales growth very strong: growth of 11.4% in 2011; 9.9% in 2012 . !
You might compare this with the consumer price index or with an index for the specific industry if available. The additional sales revenue has brought additional profit. Pre-tax profit margin over last three years 9.8%, 7.7%, 5%. [note: in 2009, it was 1.5%]. Compare with competitors performance!! Notice that in the retail industry value added is rather low so do not expect large profit margins [recall risk-return relationship] In summary, this appears to be a very solid business, generating moderate profit margins, and managing its cost structure quite well but there is no hidden goldmine in this highly competitive industry.

Abercrombie & Fitch Inc. operates in the apparel retail industry

! Abercrombie & Fitch is a leading retailer of youth apparel
[brands are Abercrombie & Fitch, Hollister, Abercrombie Kids, Gilly Hicks. [January year end] ! 1,051 stores worldwide ! Annual sales (turnover) in 2012/13..$4.5 billion producing a Net Income of $237m [2011/12; $4.1billion producing net income of $143m]

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ABERCROMBIE & FITCH CO. CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (Thousands, except share and per share amounts)
2012 2011 2010

NET SALES Cost of Goods Sold GROSS PROFIT Stores and Distribution Expense Marketing, General and Administrative Expense Other Operating Expense (Income), Net OPERATING INCOME Interest Expense, Net INCOME FROM CONTINUING OPERATIONS BEFORE TAXES Tax Expense from Continuing Operations NET INCOME FROM CONTINUING OPERATIONS INCOME FROM DISCONTINUED OPERATIONS, Net of Tax NET INCOME NET INCOME PER SHARE FROM CONTINUING OPERATIONS:

4,510,805 $ 1,694,096 2,816,709 1,987,926 473,883 (19,333) 374,233 7,288 366,945 129,934 237,011 $ $ 237,011 $

(Restated see Note 4) 4,158,058 $ 3,468,777 1,607,834 1,251,348 2,550,224 2,217,429 1,888,248 437,120 3,472 221,384 3,577 217,807 74,669 143,138 $ 796 $ 143,934 $ 1,589,501 400,804 (10,056) 237,180 3,362 233,818 78,109 155,709 155,709

$ $ $

Abercrombie & Fitch common-size income statements..

What information is immediately visible from Abercrombies 2012/13 Income Statement

! Overall, good revenue growth 8.8% in 12/13 but it represents a ! ! !
huge fall on the previous growth rateis this competition? price discounting? the economy? The gross profit is very strong consistently above 60% and very different to the Footlocker gross marginswhy? [it could be the cost category into which stores expenses are classified] Selling and marketing is a significant cost not surprising given the business model $0.44c of every sales dollar is spent on postmanufacturing activity. Margins are improving year on year.. But very consistent with the retail sector margins

Adobe Inc. is a large diversified software business

! Develops and sells software products for digital media
professionals, advertisers, publishers ! Founded in 1983..Nasdaq listed ! Global reach and exceptionally profitable ! Sales for 2012 amounted to $4.4billion, producing Net Income of $832.7m [2011; sales of $4.2b producing net income of $832.8m]

Adobe common-size income statements..

What information is immediately visible from Adobes 2012 Income Statement

! Overall, modest revenue growth 4.4% 2011-2012. Clear indication of ! ! ! !
strong market position. But, subscription income is up 46%!! The gross profit is exceptionally high 89%. Presumably because the real costs are in development see R&D. Selling and marketing is a significant cost not surprising given the business model $0.34c of every sales dollar is spent on sales and marketing. Note the write-off of purchased intangiblestells us that Adobe continues to make acquisitions. The effective tax rates vary a great deal which is unusual [2012; 25.5%; 2011; 19.5%]

The three income statements compared [Revenue - Cost = profit]

Profit margins for selected industry sectors...

Profit margins for selected industry sectors...